Until Some Catalysts Emerge, The Risks To Stocks In Europe Outweigh The Rewards

Jeff
Kleintop Analyzes and discusses international markets,
trends and events to help U.S. investors understand their
significance and financial implications. In this role,
Kleintop provides research, commentary and actionable
insights to Schwab’s client-facing teams and the firm’s
Investor Services and Advisor Services clients through
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and in-person events.

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Bond yields have fallen this year, but they began to rebound in
the United States in the latest week as the glass-half-empty bond
market realized the all-time high stock market may have it right.
But this was not the case in most of Europe. The ongoing decline
in European government bond yields continued last week and is
striking when considering how fast they were rising two years
ago. What a difference a couple of years can make. The 10-year
Italian and Spanish bond yields dropped to near all-time lows at
the end of last week, while Greece’s 10-year—once over 35%—fell
below 7% [Figure 1]. Problem solved? Not exactly.

LPL Financial

The countries once derided in the financial press for
overspending PIIGS (Portugal, Italy, Ireland, Greece, and Spain)
and thought deserving of their double-digit borrowing rates,
could now be believed to be among the GAUDS (Germany, Austria,
United Kingdom, Denmark, and Switzerland) and their low
single-digit yields. As we have highlighted several times over
the past two years, bond yields have receded as the risk of
financial crisis has passed. But the situation in Europe is
slowly transforming into an economic crisis in the form of a
potential lengthy stagnation. We had anticipated Europe could
shake off this risk and produce better growth this year—and it
still may—but the risk of a setback rose last week.

The risk can best be seen in prices. Central bankers around the
world, including the U.S. Federal Reserve (Fed), the European
Central Bank (ECB), and the Bank of Japan (BOJ), have a clearly
stated goal of 2% inflation, to motivate spending and lift wages
while leaving a buffer above zero when growth inevitably slows
again. While the inflation rates in the United States and Japan
are just below that and rising, the pace of inflation in the
Eurozone has been under 1% since October 2013 and is still
decelerating.

Last week, rather than making a move at its meeting to cut rates
or take other actions, the ECB took a gamble that the economic
momentum in the Eurozone may be self-sustaining enough to turn
prices higher on its own. The status quo announcement was
accompanied by the release of the ECB’s forecast for inflation in
the coming years, showing it expects inflation to remain below 2%
through 2016. Not only has the ECB refrained from any new
stimulus, it has been outright shrinking the bonds on its balance
sheet for over a year now, in contrast to the Fed, which is just
starting to slow the growth in the bonds on its balance sheet by
tapering its pace of bond buying [Figure 2].

LPL Financial

The problem for Europe is an elevated risk of economic
stagnation, a rise in the value of the euro hurting exports, and
very low rates of inflation making it very hard for countries to
address their debt and pension problems. Despite years of
austerity in the form of tax hikes and spending cuts, Eurozone
government debt-to-GDP (gross domestic product) has risen to a
record 93%, up 4% from a year ago, according to Eurostat, the
official statistics office of the European Union (EU). Higher
inflation is necessary for the Eurozone to avoid what Japan has
experienced — a high debt and pension burden coupled with flat
inflation and economic growth for much of the past two decades.

We remain hopeful that in 2014 Europe can overcome its weaknesses
and have a better chance for returns competitive with U.S.
markets than last year. Here are the catalysts we are looking for
to turn more positive on European stocks:

Lower expectations for earnings growth – The
current earnings expectations are likely to be disappointed.
The consensus of analysts’ estimates for European company
earnings are for 12.2% growth in 2014. This seems high given
prospects for only about 1% GDP growth, especially compared
with the consensus for the United States, which now aligns with
our outlook for 8.8% earnings per share growth for the S&P
500.

Lower valuations – Although European stocks
usually trade at a discount to U.S. stocks due to a different
sector mix and slower growth, at a forward price-to-earnings
(PE) ratio of 13.3, compared to 15.8 for the S&P 500 Index,
the discount is not sufficiently pricing in the greater risk of
economic stagnation.

Inflation picking up back above 1% and rising
– A key sign that the risk of deflation is receding.

ECB action – If the euro moved toward $1.45 or
longer-term inflation expectations fell, it may prompt a move
by the ECB to reduce the risk of stagnation, which markets
would welcome.

Loan demand picking up – Signs that business
loans are increasing, rather than the declines indicated in the
surveys, would be a welcomed sign that the bridge is being made
between recapitalizing the banks and getting them lending
again.

Despite inflation being in the ECB’s “danger zone” and rising
debt burdens, the ECB made a bet last week that the Eurozone
economy is picking up fast enough to avoid the need for any
further stimulus. We are not so sure. Until some of the above
catalysts emerge, the risks to stocks in Europe may outweigh the
rewards.